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States and the Federal Fiscal Cliff

The effect of higher federal taxes and sequestration cuts on state budgets and revenue.
by , | October 11, 2012

For full coverage of the fiscal cliff's impact on states and localities, click here.

When the Urban Institute convened a briefing on the "fiscal cliff" -- the impact of federal tax cuts set to expire and spending cuts due at the start of the new year -- an A-list of economists showed up. Among them, Bob Greenstein, founder and president of the Center on Budget and Policy Priorities; Douglas Holtz-Eakins, president of the American Action Forum and former economic adviser to John McCain's presidential campaign; and Donald Marron, director of the Urban-Brookings Tax Policy Center.

The panel played to a packed house, and despite partisan differences, agreed upfront that if all of the tax cuts were allowed to lapse and spending cuts allowed to take place, the national economy would fall into another recession -- a self-inflicted wound, but a real-world downturn nonetheless.

Americans' taxes alone would increase by more than $500 billion in 2013, or almost $3,500 per household. (The increases would reflect the expiration of the Bush-era tax cuts too.) "Close to 90 percent of households will see their taxes go up," Marron said. "It involves almost everybody."

The fiscal cliff "is an extreme danger to the economy. It's 4 percent of GDP," says Holtz-Eakins. As he sees it, a reaction to both the potential tax increases and spending cuts is already taking place. "There are anecdotal reports of businesses scaling back plans, of defense contractors sending out notices about layoffs," he said. "If the tax rate on [stock] dividends goes from 15 percent to 40 percent, you're looking at [a lot of people making a change to some of their] investments."

Holtz-Eakins noted that there seems to be a "consensus that the payroll tax extension will go away." But, he added, "there's a real premium on avoiding the rest of the tax hikes and spending cuts. The sequestration spending cuts are horrifically bad policy. [They have] to be replaced with longer range cuts that get the same amount of deduction -- that's the hardest thing to get done in a lame duck session."

Holtz-Eakins also warned of the looming debt limit increase due early next year. If Congress doesn't deal with that and lets the fiscal cliff issues fester, "the rating agencies will downgrade U.S. debt. If Congress does not make progress [on these issues] during the first year, we will be downgraded," he said.

As to when Congress might act, most of the panelists expected significant action during the winter months. "It's more of a slope than a cliff," Greenstein said. "We won't go into recession on Jan. 2. The $500 billion comes out of the economy over the course of 12 months. The farther down the slope you go, the bigger the problem is."

Greenstein's biggest worry is the risk to the economy in the long term if Congress doesn't act. He believes they will. "There will be pressure to work together and reach a grand bargain," he predicted, noting that some of that pressure will come from the financial markets which are nervous about the volatility the cliff represents.

As to sequestration, "When the federal government starts reducing its deficit, watch out below," John E. Petersen noted in January 2011,

Sequestration cuts could "force states to backfill funding and scale back countless safety net programs," reported Stateline.org. The cuts would be divided between defense and non-defense discretionary spending. In the next fiscal year alone, non-defense spending would be cut $38 billion or by 7.8 percent across the board.

The big question for states, Greenstein noted, is whether the feds will shift more costs to the states, such as Medicaid. "What I would tell governors is: 'Contact your congressional delegation,'" he said. "Urge them not to go below budget control caps, and advise them not to shift Medicaid costs to the states."

Amidst all the doom and gloom, there is a sliver of good news for states: States that piggyback their income taxes on the federal code could see a revenue bonanza at end of 2012, as some taxpayers sell stock to cash in on lower capital gains taxes and increases in the tax on dividends. Marron’s advice to governors and state legislators: “Don’t build that revenue bump into expectations for the future.”

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